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James Nolan - University of Saskatchewan

February 5, 2008

To whom it may concern;

The following is a submission applicable to Canadian Transportation Agency (hereafter CTA) Decision No. LET-R- 218-2007 Review of the Railway Interswitching Regulations, dated December 20, 2007. In the context of this CTA decision, I will suggest to the Agency two modifications to existing interswitching policy, each founded upon published academic work by this author. As will become clear, the suggested policy changes should not to be implemented independently, but instead must be considered as a set that should be implemented concurrently for optimum impact.

The quality of my academic work on this issue is unique among transportation academics and professionals in Canada. Recently, my published contributions on the topic of rural and agricultural transportation were recognized by the Transportation Research Forum in the United States. I am the only academic based in Canada listed as part of an extensive TRF Compendium of Agricultural and Rural Transportation Publications covering the years 2004-2006.

Competition policy in the rail sector

For many years, public policy towards natural monopolies (i.e. public utilities with declining average costs over the relevant range of output) used price regulation to compel the monopoly to set price at or near marginal cost. In return, government provided these firms with a subsidy to continue to operate within the natural monopoly cost structure. This policy essentially ensured public service obligations were met by utilities. The rail sector in Canada, as an industry with declining average costs over a considerable range of output, was no exception to this policy.

With the growth of intermodal competition across many transportation markets in Canada, in 1967 the policy of government subsidy to the rail industry was abandoned, with the notable exception of grain movement throughout Western Canada. Grain continues to be an important commodity to the rail industry – grain transportation still accounts for just over 20 percent of railway revenue in Canada. Today, the remaining vestiges of rate regulation on grain movement have been scaled back to the point that railways in Canada now have considerable freedom (under the revenue cap scheme) to set grain freight rates closer to average cost, a policy that helps sustain subsidy-free operations on a system wide basis (Boyer, 1998). For a variety of reasons, including a desire on the part of the Federal government to render transportation in Canada more competitive and less reliant on regulation (Transport Canada, 2003), the public service element of regulatory oversight in grain movement is arguably less of a focus now than at any other time in Canadian history. This observation, combined with the fact that the two Class I railways are currently earning near-record profits indicates that there is a pressing need to re-examine regulatory and competition policy in this sector.

Canadian rail regulators have historically recognized that where it occurs, market power in the rail sector is an inherently spatial issue. The partial deregulation of 1967 was premised on the fact that there are many markets and movements where railways compete very actively for business. But there are other markets and movements in Canada where railways hold a degree of market power because transportation competition is not readily available to local shippers. In light of this, the extant set of interswitching regulations and associated subsidies on these regulated movements (i.e. the regulated interswitching rates) were modified significantly in 1987 as an improved remedy for shippers in those situations where spatial market power was being exercised (Grimm and Harris, 1998). However, it is clear that the spatial metrics used in the 1987 regulations were conceived at a time when shipper locations within our national rail networks, especially in the Western Canadian grain handling sector, were considerably denser than at present. More recent evidence presented in a paper by Nolan and Skotheim (2008) shows that while well intentioned, the general policy of interswitching in Canada should be changed through the expansion of the radial or spatial limits of (extended) interswitching. At a minimum, such a change simply updates 20 year old policy to better reflect the enormous changes that have occurred in the Canadian rail (and grain) transportation landscape.

Given the current network structure of the Class I railways in Canada, it makes sense that for interswitching to be effective in creating real or potential competition with the associated likelihood of reduced rates for affected shippers, the legislation must be modified to expand the effective radius of an extended interswitch by at least twofold, or even up to three times the current limiting radius of 30 km. As simulated in the Nolan and Skotheim paper, this simple change could generate significant benefits for grain shippers. The possibility of similar gains to other shippers is ultimately an empirical question, but we expect that grain shippers would be the primary beneficiary of such a change.

As a note of caution, my research has shown that when applied in the spirit of the current legislation, interswitching can serve as an effective competition policy for the Canadian rail sector. However, the CTA needs to be careful to ensure that this spirit is upheld – interswitching policy will only be successful as competition policy if all railways are compelled by law to offer service using interswitching when it is demanded by an eligible (i.e. located within interswitching limits) shipper. The Agency understands that there is considerable scope for strategic behaviour (e.g. refusal to offer competing service, physically altering the interswitch points, etc.) under this policy, so they need to continue to be vigilant if the suggested policy changes are to work for the public interest.

Costs under regulation

Informed regulation starts with accurate costing of the regulated firms. As is well known, rail costing is very difficult due to the joint or common nature of many rail fixed and/or variable costs. Therefore, rail costing often requires difficult or poorly informed choices by regulators about apportioning costs to output. For example, in the U.S. there is still considerable debate about rate setting and the minimum level of contribution for fixed costs necessary for financial sustainability.

As stated in the communiqué, the CTA currently assumes a 7.5% contribution to fixed costs for determining its regulated interswitching rates. In light of the first policy suggestion above, it is imperative that the allowable contribution to fixed costs contained in the regulated interswitching rates is set so as not to hinder financial viability. In other previous research using a rail costing model for Canada (Carlson and Nolan, 2005), we assumed a contribution of 20% towards fixed costs in our computations, an amount greater than that assumed in most academic research on the subject.

If the changes to interswitching policy described above are implemented, only then should the Agency re-evaluate the applicable interswitching rates (listed in the Table in the communiqué of December 20, 2007) to reflect a reasonable contribution towards the fixed costs of these longer movements. As a starting point for this process, I suggest that if new interswitching radial limits are adopted, then the Agency should double the contributions to fixed costs. This will require re-computing applicable interswitching rates to reflect a 15% contribution under the new policy. Note that this latter amount is at the lower end of the scale as typically requested by US railways in debates about rate setting (Tye, 1991). In this light, my suggested level of contribution is best viewed as a sort of "middle ground" from which the Agency should actively evaluate if it is sufficient compensation for railways to maintain viability under any new interswitching regime.

To expedite the process of submission, the references to my personal research are available upon request (james.nolan@usask.ca) if necessary to support the policy changes suggested here.